Profits and Economic Development

by Dan Schwab and Eric Werker

Executive Summary —
"Without development there is no profit, without profit no development," wrote economist and political scientist Joseph Schumpeter in his landmark book The Theory of Economic Development. An open question, however, has been whether excess profits—known as rents—are good for development. Economic theory thus far supports both sides of the argument, yielding conflicting advice for competition policy and anticorruption efforts. This paper examines the question by analyzing a comprehensive industry—level dataset of manufacturing sectors—and by applying methods of the competition-and-growth scholarship of economist Philippe Aghion and colleagues. This approach allows the analysis of industry-level profitability (as opposed to individual firms) and the overall growth of the economy. Evidence suggests that rents, as measured by a high-markup that is also an indication of low competition, seem to slow growth in productivity or output. The effect is strongest in poor countries. Higher rents are associated with a slower removal of tariffs, implying that firms rent-seek to prevent competition and maintain their high margins. This investment in rent-seeking may be in lieu of investment in innovation or new productive assets, which slows the overall growth of the sector. Furthermore, in industries in which high profits should be essential in generating growth, those sectors that would otherwise need external finance but in a country with weak financial markets, the negative impact of rents on growth is especially strong. Findings also show that countries with more rents in the manufacturing sector grow slower even when other controls are introduced. Key concepts include:

What may be good for the players in one industry may not be good for the economy at large.

A country's average mark-up is a strong negative predictor of future economic growth.

Poor countries grow faster than rich countries because of the benefits of catch-up, but those countries also tend to have higher rents, which slows growth.

Developing countries have a tailwind from being poor in the catch-up sense, but a headwind from being poor through an inferior political economy of rent-seeking business.

Author Abstract

Using industry-level manufacturing data, this paper demonstrates a negative effect of rents, measured by the mark-up ratio, on productivity growth. This result is robust to alternate specifications, including an instrumental variables approach. The negative effect is strongest in poor countries, suggesting that high profits stymie economic development rather than enable it. Consistent with the rent-seeking mechanism of the model, we find that high rents are associated with a slower reduction in tariffs. A country's average mark-up is a strong negative predictor of future economic growth, indicating that we may be measuring a phenomenon of the broader business environment.